The Essential Buffett: Timeless Principles for the New Economy / Edition 1

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"In this book, Robert G. Hagstrom helps you draw on the wisdom and counsel of Warren Buffett to succeed in today's challenging market. Hagstrom explains how Buffett analyzes companies and selects stocks. He then shows you how these techniques can be applied to technology, small-cap, and international stocks - areas Buffett traditionally has not explored." "Buffett built a multibillion-dollar business empire by confidently following a course that often put him at odds with Wall Street trends. The Essential Buffett outlines the core principles that you will want to incorporate into every stock decision you make: invest in a business, not a stock - you'll look at a company's economics as if you were taking over as CEO tomorrow; demand a margin of safety for each purchase - how to keep risk at a minimum; manage a focus portfolio - a comprehensive portfolio strategy, used with spectacular results by Buffett, which focuses the investment process on a few outstanding companies; and protect yourself from the speculative and emotional forces of the market - a lesson thousands of investors have now come to appreciate the hard way."--BOOK JACKET.
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Editorial Reviews

Hagstrom revises, updates, and expands his analysis of Warren Buffett's investment methodology, often excerpting from his earlier works. He covers both his stock selection and his style of portfolio management, and throws in advice on how to apply the principles. Annotation c. Book News, Inc., Portland, OR (
From the Publisher
"A comprehensive primer on applying Buffett's investment strategy to the new economy." (Fortune, April 30, 2001)
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Product Details

  • ISBN-13: 9780471389798
  • Publisher: Wiley, John & Sons, Incorporated
  • Publication date: 3/1/2001
  • Edition number: 1
  • Pages: 304
  • Product dimensions: 6.32 (w) x 9.61 (h) x 1.07 (d)

Meet the Author

Robert G. Hagstrom is the author of The Warren Buffett Way: Investment Strategies of the World's Greatest Investor; The Warren Buffett Portfolio: Mastering the Power of the Focus Investment Strategy; the Nascar Way: the Business That Drives the Sport, and Latticework: The New Investing. Hagstrom is Senior Vice President of Legg Mason Funds Management and Director of Legg Mason Focus Capital.
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Read an Excerpt

Chapter 1: The Unreasonable Man

Forty-five years ago, Warren Buffett began a career managing money. At the relatively young age of 25 and with a relatively small amount of capital (his own investment was only $100), Buffett started an investment partnership. With the support of family members and a few close friends, the Buffett Partnership began operations, on day one, with $105,000 and seven limited partners.

Buffett set himself a tough goal: to beat the Dow Jones Industrial Average by ten percentage points each year. He achieved that and more. From 1956 until 1969, the year the partnership disbanded, Buffett generated an average annual return that was 22 percentage points higher than the Dow. Along the way, the partnership took a controlling interest in a small textile company called Berkshire Hathaway. Over a 35-year period, Buffett grew its book value from $19 per share to $37,987 per share. That works out to a rate of 24 percent compounded annually. It is not surprising that Warren Buffett was recently voted the greatest investor of the twentieth century.

When we look back on the life of Warren Buffett, we can identify several important experiences that helped him become successful. He was raised in a loving home under the moral guidance of two parents who exemplified midwestern values. His father, a stockbroker and U.S. Congressman, stressed both honesty and integrity in all his dealings with clients and the public. Young Buffett had an entrepreneurial streak from the beginning; he quickly learned to appreciate the value of a dollar and, just as important, the value of growing a dollar. Taken together, Buffett's early personal experiences helped provide him with a lifelong moral compass.

In addition to this strong moral foundation, Buffett possessed a seemingly inexhaustible appetite for knowledge. While working at his father's brokerage firm, he devoured all the investment books he could find, which led him ultimately to one of the greatest investment books ever written: Ben Graham's The Intelligent Investor.

But it is not enough to say that Buffett's investment success is simply a result of good character and a good education. To this we must add the all-important characteristics of courage and self-confidence. Buffett deeply believed in the lessons taught by his father and by Ben Graham, so he was unafraid when he found himself at odds with the more popular Wall Street view. This quality, which we might call "intelligent contrarianism," has most helped Warren Buffett achieve remarkable success.

"The reasonable man adapts himself to the world," wrote George Bernard Shaw. "The unreasonable one persists in trying to adapt the world to himself. Therefore all progress depends on the unreasonable man."1 Shall we conclude that Warren Buffett is "the unreasonable man"? To do so presumes that his investment approach represents progress in the financial world, an assumption I strongly make. For when we look at the recent achievements of "reasonable" men, we see, at best, mediocrity and at worst, disaster.

After the 1973-1974 bear market, the U.S. economy endured several difficult years. Not until 1981 were we able to finally throw off the shackles of high inflation and high interest rates, setting the stage for a new bull market. And did we ever have one! In the past 20 years, we have seen the Dow Jones Industrial Average rise from 1,000 to over 10,000.

Another interesting trend during this extraordinary period of price appreciation is the increased activity and interest level of individual investors. Using Individual Retirement Accounts, self-directed 401(k) plans, discount brokers, and electronic trading, individuals have taken a much more hands-on role in managing their own financial affairs. The net effect has been to shift a large portion of financial assets and decision making away from professional investors.

This in no way implies that professional investors have been left with little to do. On the contrary, they have kept themselves busy inventing program trading, leveraged buyouts, derivative securities, and index futures. And they have launched hundreds of hedge funds at a dizzying pace. These funds have shown the ability to roll financial markets, crush foreign currencies, and put to risk the economies of entire countries. This constant game of "I can design a more complex strategy than you can," played at a feverish pace in order to generate the highest return in the shortest period of time, has frightened many investors.

Today, the distinction between one money manager and another has faded. Fundamental research has been replaced by the whir of computers. Black boxes have replaced management interviews and company investigations. Automation has replaced intuition. As a consequence, professional money managers have put more distance between the financial securities we own and the businesses these securities represent. No wonder the average investor is becoming more of a do-it-yourselfer. No wonder passive index investing has increased in popularity. With most money managers unable to add value to their clients' accounts, active money management is increasingly viewed as a "satellite" strategy, a smaller adjunct to the much larger indexing strategy...

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Table of Contents

1 The Unreasonable Man 1
Lesson 1 4
Lesson 2 7
A Better Yardstick 10
Lesson 3 13
The Search for Patterns 15
Why Has Wall Street Ignored Warren Buffett? 17
A Different Way of Thinking 18
2 The World's Greatest Investor 23
Investment Beginnings 24
The Buffett Partnership, Ltd. 25
The Early Days of Berkshire Hathaway 26
The Insurance Business 27
A Mosaic of Other Businesses 33
The Man and His Company 41
3 Lessons From the Three Wise Men of Finance 47
Benjamin Graham 48
Philip Fisher 61
Charlie Munger 68
A Blending of Influences 71
4 Guidelines for Buying a Business: Twelve Immutable Tenets 77
Business Tenets 80
Management Tenets 84
Financial Tenets 94
Market Tenets 101
The Coca-Cola Company 106
The Intelligent Investor 121
5 Focus Investing: Theory and Mechanics 123
Focus Investing: The Big Picture 127
Do the Math 132
Modern Portfolio Theory 148
6 Managing Your Portfolio: the Challenge of Focus Investing 161
John Maynard Keynes 163
Charles Munger Partnership 166
Sequoia Fund 168
Lou Simpson 171
Three Thousand Focus Investors 174
A Better Way to Measure Performance 177
Two Good Reasons to Move Like a Sloth 189
Fair Warning Label 194
7 The Emotional Side of Money 197
The Temperament of a True Investor 198
8 New Opportunities, Timeless Principles 217
Beyond Buffett 218
Technology Stocks 220
Smaller and Mid-Capitalization Stocks 233
International Stocks 240
Learning from the Best 250
Notes 253
Acknowledgments 267
Index 271
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Interviews & Essays

Exclusive Author Essay
What Makes Warren Buffett Successful?

Warren Buffett was recently named the greatest investor of the 20th century. Few people would argue with that assessment of his abilities. After all, Buffett managed money for almost half the century and achieved outstanding results. He began an investment partnership in 1956 with the goal of outperforming the Dow Jones Industrial Average. During the partnership's 13 year existence, Buffett not only beat the Dow but was able to best the index on average by 22 percentage points. When he assumed control of Berkshire Hathaway in 1965, his goal was to grow the book value of Berkshire at a rate greater than the growth rate of the average American company. Over a 35-year period (1965-1999), Berkshire's book value grew from $19 per share to $37,987 per share -- a 24 percent compounded annual return that far outdistanced the return of the Standard & Poor's 500 Index.

If we look back over the last half of the 20th century, investors faced countless challenges: a cold war with the Soviet Union, Vietnam, riots and civil strife, political firestorms, and a presidential resignation. We endured a national energy crisis, a severe economic recession, stagflation, and double-digit interest rates. There were several market cycles with corresponding booms and busts. Investors enthusiastically embraced the computer revolution and biotechnology promises, as well as the Internet craze. They signed up for leveraged buyouts, junk bonds, portfolio insurance, low p/e investing, high p/e investing, thematic investing, as well as momentum trading. Through it all, they watched countless fortunes rise and fall, and each time the smoke cleared, there stood Warren Buffett. Like the tortoise who raced the hare, Buffett was not always the swiftest, but he was the surest.

I am often asked what makes Warren Buffett successful. After studying his methodology over the last 15 years, I can now encapsulate his secret in three easy doses. First, think about stocks as businesses. Second, manage a focused, low-turnover portfolio. Third, understand the difference between investment and speculation.

For too long, investors have relied on shortcut methods to try and determine a stock's value. Mistakenly believing that a stock's low price-to-earnings ratio indicates value and a high stock to price ratio reveals overvaluation, many have been trapped owning lousy businesses while forgoing better cash-generating companies. Single-factor accounting metrics can be a starting point in the valuation process, but as Buffett tirelessly explains, only a company's cash-generating ability determines value. Business owners recognize the most important variable in running a company is how much cash a business can generate. If a company consumes all of its profits just to maintain its operating position, no value has been created for the business owner. But a business that generates far more cash than is needed by the company quickly increases in value. A company whose stock price is low in relation to its earnings may generate excess cash, in which case low p/e investing would be profitable. But what about the company whose stock price is low in relation to earnings but has to reinvest all its profit just to maintain its present level of sales and accounting earnings? In this case, low p/e investing can be very unprofitable.

When Warren Buffett looks at a stock, he thinks about the underlying business, the management, the financial results of the business, and then finally the company's value determined by discounting to present value the future cash flow of the business. It does not matter to Buffett if the stock price is high or low in relation to its earnings, its book value, or whether the company pays a dividend or not. These accounting metrics do not ultimately determine business value.

The second part of Buffett's success is his willingness to concentrate his portfolio into only a few names. Whereas other money managers might prefer to own 50-100 stocks diversified across all the major industry groups, Buffett instead prefers to isolate his portfolio around his best business ideas. Modern Portfolio Theory equates risk with price volatility. Buffett equates risk with economics. If Buffett's portfolio is comprised of 10 high-quality and economically strong businesses, it matters not to him that this portfolio may have higher price volatility compared to a more broadly diversified portfolio. Give the choice between a portfolio that generates a "smooth" 10 percent return compared to a portfolio that provides a "bumpy" 15 percent return, Buffett will chose the bumpy ride and hence the higher total return.

The third part of Buffett's success is his ability to recognize the line drawn between investment and speculation and the discipline to never cross the line. An investor is only interested in the economic return of an investment. A speculator is interested in the behavior of the market or more specifically the near-term behavior of individual stock prices. Academics have demonstrated quite convincingly the relationship between a stock price and its cash earnings ability correlates strongly after three years. In shorter periods, we know stock prices can move up and down for a host of reasons that do not include a company's long-term economic potential. Specifically, the psychological forces of fear and greed play a major role in the behavior of stock prices over the short run. As an investor, Buffett has been able to distance himself from the speculative forces of the market, choosing instead to focus his attention on the economic returns of the companies he owns. His competitive advantage as a successful investor is very much about not letting the speculative side of the market seduce him into making low-probability bets -- guessing the short-term direction of markets.

Warren Buffett is quoted as saying, "Investing is easier than you think but harder than it looks." Understanding a company from a businessperson's perspective may take a little more work than just doing simple math and managing a focus portfolio; it will occasionally challenge the investor to understand and not fear the volatility of their portfolio, and finally, ignoring the speculative force of the market will require emotional fortitude. Yes, to invest like Warren Buffett is a little harder than you think, but once you master his basic principles a lifetime of investing becomes easier than you think. (Robert G. Hagstrom)

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  • Anonymous

    Posted April 3, 2001

    Misleading Premise for the Book Reduces Its Value

    The definitive book on Warren Buffett has yet to be written. Perhaps only Mr. Buffett can do so, and he has no incentive in this direction. Interestingly, the more Mr. Buffett's performance weakens versus the market, the more books come out focusing on his methods. Mr. Buffett writes about his thinking in his annual reports of Berkshire Hathaway, speaks about it at his annual meetings, and occasionally shares ideas with reporters. Conclusions about his methods then are a distillation of these sources, much like the CIA used to interpret what the Soviet's thought by reviewing Pravda. The results are probably about as accurate. My main complaint about this book is that Mr. Buffett does not and probably will not invest in the new economy. And for good reasons. It doesn't fit his investing standards. So a book that takes the principles and applies them in that direction is misleading at best, and I suggest you decide what you want to call it at worst. If you want to read a good book about Mr. Buffett, I suggest that you read How to Think Like Benjamin Grapham and Invest Like Warren Buffett. That volume covers much of the same ground as here, but does so better. It also is more accurate in characterizing Mr. Buffett's philosophy, as I understand it. You can read my review of that book. If you have read Mr. Hagstrom's book, The Warren Buffett Way, you probably don't need to read this one as well. Let me summarize some of the key points so you can decide. Here are the principles in the book, as I have paraphrased them: (1) Think about a stock investment like you are buying the whole business. (2) Give yourself a large margin of safety when you buy, picking a time when a stock is depressed well below its economic value. (3) Hold few stocks and think about their current and future fundamentals constantly to see if your assumptions are holding. (4) Avoid speculation at all costs. The tenets of The Warren Buffett Way are repeated here: Business Tenets (a) 'Is the business simple and understandable?' (b) 'Does the business have a consistent operating history?' (c) 'Does the business have favorable long-term prospects?' Management Tenets (a) 'Is the management rational?' (b) 'Is management candid with shareholders?' (c) 'Does management resist the institutional imperative?' Financial Tenets (a) 'Focus on return on equity, not earnings per share.' (b) 'Calculate owner earnings.' This is essentially free cash flow. (c) 'Look for companies with high profit margins.' The reported reason Mr. Buffett does not buy technology stocks is because he feels the long-term prospects are too murky. He is probably right in most circumstances. Technology companies are usually about as successful as their new products. How can you know how good they will be versus the competition 10 years from now? The fundamental premise of a book like this is also questionable in another way. If you want to get Warren Buffett's results, you can simply own Berkshire Hathaway stock while Mr. Buffett is alive. For most people, indexed mutual funds are a better choice. I suggest that you read John Bogle's Common Sense on Mutual Funds to learn the argument for that approach. If 90 percent of the pros cannot beat the market, can you expect to do better? After you read this book, also think about where modeling of a famous person's behavior might not capture what you want to learn. For example, can an actor distill her or his approach into a few principles and tenets? Yes, but that distillation wouldn't allow you to duplicate the results. Take your money seriously, and keep focusing on how to keep it safe as your first investment priority. Avoiding losses is a key Buffett principle that has served him and his investors well. Donald Mitchell, co-author of The Irresistible Growth Enterprise and The 2,000 Percent Solution

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